Why the conventional wisdom on currency is wrong

Now that talk of a US economic `house of cards' has begun to subside, attention should be paid to misunderstandings on exchange rates

By Rudi Dornbusch

Two views about today's prevailing exchange rates exist: the dollar is overvalued and the yen needs a deep depreciation. The implication of the two is an explosion upward for the euro. But can Europe deal with such a shock, and what would happen to the US if that happened?

Now that America's recovery is underway -- and it arises from a slump, not a recession -- the current account deficit will widen even further and in no time discussions about the unsustainable high-flying dollar will become fashionable again. Yet, the very fact of a US upswing that is bigger, comes sooner, and is better than anywhere else -- Europe remains plagued by growth cramps and Japan's economic policy kabuki is going nowhere -- will support and even strengthen the dollar.

All those who predicted the collapse of America's "house of cards" economy (who thought that Enron's collapse was finally the sign in the sky that they were right) must now be exhausted. No dollar collapse looms. Financial stability, strong productivity, flexibility and dynamism make the US one of the choice places for capital, and this influx of capital finances America's large current account deficits. It will continue doing so until, at the end of the rainbow, Japan or Europe compare favorably with the US investment climate. Don't hold your breath for that day; don't wait for the US$1.20 per euro that is touted as the "equilibrium" rate.

But the dollar is not the only issue atop currency market debates. There is another strongly held belief: that Japan cannot recover without a steep decline in the yen. For those who hold this view, the yen would have to decline to ?160 or even ?200 to the dollar. Without monetary policy, fiscal policy or supply side reforms, how else can Japan return to growth except by a depreciation-driven export boom? Because Japan's export sector is so small, barely 10 percent of GDP, the depreciation would have to be enormous to stoke the entire economy.

Suppose we put the two propositions together: the yen depreciates 30 percent against the dollar while the dollar in turn depreciates 30 percent against the euro. These numbers are large but such falls are in everyday discussion. The implication, of course, is a huge appreciation of the euro against everybody else. Japan might get some growth, probably not even a full percentage point of GDP. For the US the story is mostly neutral: a gain in competitiveness toward Europe, a loss relative to Japan, and with no net gain or loss in competitiveness or trade, scant inflationary effects to speak about, no interest rate hikes or stock declines -- nothing to get excited about.

But that would not be the story in Europe. A huge yen depreciation and sizeable decline in the dollar would hit European competitiveness and growth hard. Empirical models that try to quantify the impact of exchange rate changes suggest that without an aggressive monetary policy response, a 40 percent euro appreciation would knock 2.5 percent off European growth.

This number is not at all surprising if we remember that growth in the past few years was substantially due to the euro's weakening; this time round, the euro strengthening would take it all back. Even as European growth turns down, sharply lower import prices would also bring down inflation. That opens the door for a dampening the damage if the European Central Bank vigorously responded by cutting rates. "Vigorous," however, is not a word one often used to describe the ECB, so there is a serious problem.